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Leverage and “alpha”

Quantopian

Yes, having read your definitions I am now clear what you are saying. I am very, very torn indeed on the question of “alpha” and indeed have severe doubts as to its existence. And indeed as to its very definition.

“Beating the averages” is of course what is generally meant by alpha. But I am not at all sure that the “averages” is necessarily a helpful definition. The averages is taken to mean the manager benchmark but there are are so many “averages” that the expression has become almost meaningless especially since the modern tendency towards so called “smart beta”.

Take the S&P 500. If a manager consistently beats the return of the market cap weighted S&P 500 which he quotes as his benchmark, has he created “alpha”? Well, if he had chosen a different benchmark such as the equal weighted S&P 500 over many periods he may find he had NOT beaten the “average” and so his alpha disappears.

It’s all relative.

The market cap weighted S&P 500 is merely one of a number of ways to define the “market”. It is certainly not the only way as we have seen with the simple example above. And it is of course myopic to consider the US alone as a definition of the “market” when arguably in the global age the global market would be a better yardstick. With increasing certainty the longer the timescale.

I understand very clearly your very simple proposal that leverage increases returns under some circumstances and the arguments as to why this will not be the case in all circumstances are too well rehearsed to repeat.

On perhaps a rather different tangent I have come to seriously doubt the wisdom of “trading” as such. A systematic approach to investment (such as an index) yes, no problem. The use of technical or even fundamental indicators to “improve” upon the simple trend following nature of an index- I have my doubts.

I am absorbing all I can about machine learning at present and the journey is fascinating. I believe it may help guide asset allocation. I believe it may help to point out short term market anomalies such as arbitrage opportunities. But I am under no illusion that ML can predict the future or make a Midas out of you.

What I am saying is that I believe much of what most traders attempt is doomed to failure over the long term  unless you engage in front running or market making or arbitrage or inside information (all of which are practiced on a daily basis by the hedge fund community).

As to leverage I am not at all sure that in the long term it will help much when history tells us unleveraged investments all too often are subjected to horrendous drawdown. But of course that is merely my opinion and in the short term (however you want to define that) it can work wonders for your bank balance if you have the luck or skill to avoid a Black Swan.

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